The IRS recently took a shot across the bow of limited partners of investment management companies with respect to the application of self-employment tax (or, SE tax, for short). In fact, the ruling could potentially affect limited partners (including LLC / LLP partners) in every industry. While this tax issue has been fought on several levels over the past 20 or more years, it had gone dormant since 1997. Now, an IRS Chief Counsel Advice (ILM 201436049 (05/20/2014)), released on September 5, 2014, (the “ILM”) demonstrates that the IRS may be ready to renew the fight.

Currently, limited partners of limited partnerships and shareholders of Subchapter S corporations routinely take the position that their distributive shares of entity profits are exempt from SE tax. The uncapped Medicare hospital insurance portion of the SE tax for high income taxpayers is now 3.8%, thanks to a 0.9% increase brought in at the close of 2012 to match up with the new Net Investment Income tax. In the S corporation world this tax exemption is tempered by a requirement to pay reasonable compensation to S corporation shareholders (the compensation, unlike stock distributions, is subject to SE tax). In the world of limited partnerships the SE tax exemption does not extend to guaranteed payments for services which, for partners, are akin to salary.

The ILM deals with a fairly large investment management company (likely in New York City based on its structure), which acts as an investment manager for a family of funds (each treated as a separate limited partnership). The IRS did not attack the allocations to the GP which held the profits interest in each underlying fund. The Service was interested in only the management company and its treatment of the management fee income. The management company in the ILM was structured as a limited liability company or LLC which was treated as a partnership for tax purposes. It was stated that the LLC was a successor to a previous management company that was organized as an S corporation (this fact was not material to the analysis but did help explain why the management company was taking the tax positions it was). Each partner in the management company received a salary (erroneously reported on a Form W-2) and guaranteed payments, both of which were subject to SE tax. In addition, each partner received allocations of partnership profits which were not subject to SE tax. Some of the partners were investment managers but others were legal, human resources, information technology services and other infrastructure personnel.

The IRS pointed out that Section 1402(a)(13), which exempts limited partners from SE tax, was enacted in 1977 prior to the proliferation of LLCs. It also cited case precedent indicating that LLC members were not limited partners and were not entitled to the benefits of Section 1402(a)(13). However, the Service went much further and pointed to the legislative history of the statute to advocate that the statute was not intended to shield limited partners from SE tax to the extent they were providing services to the partnership. Rather, the Service claims, the statute was merely intended to exempt passive investors from SE tax. The ILM also cites extensively to Renkemeyer vs Commissioner, 136 T.C. 137 (2011), in which the Tax Court unsurprisingly found that partners in a law firm formed as a limited liability partnership were subject to SE tax on their earnings. The Tax Court also utilized broad language and cited to the intent of the statute and its related legislative history. The ILM ultimately found that every partner of the management company was subject to SE tax on their allocations of earnings because the “Partners’ earnings are not in the nature of a return on a capital investment … [but rather]… are a direct result of the services rendered on behalf of Management Company by its Partners.”

This fight over SE tax related to limited partners and LLC members began in the early 1990s. In 1994, Treasury issued proposed regulations that would have exempted LLC members from SE tax but only if the member lacked authority to make management decisions necessary to conduct the business of the LLC. In January of 1997, Treasury withdrew the regulations and re-proposed new regulations. The 1997 regulations would treat individuals as limited partners and able to take advantage of the SE tax exclusion unless the individual (i) had personal liability for the debts of the partnership, (ii) had authority to contract on behalf of the partnership, or (iii) participated in the activities of the partnership for more than 500 hours during the taxable year. Importantly, the 1997 proposed regulations were not limited to LLC members. Rather, it would have changed the SE tax situation for all partnerships.

Shortly after the 1997 proposal, Steve Forbes called the proposed regulations, “a major tax increase by a stealth regulatory decree.” Others soon joined in a national campaign to kill the regulatory proposal including the then Speaker of the House, Newt Gingrich and radio talk-show host, Rush Limbaugh. In June 1997, the Senate passed a nonbinding resolution declaring the proposed regulations outside the scope of Treasury’s authority, urging Treasury and the IRS to withdraw the proposal. Congress ultimately imposed a 12-month moratorium on Treasury’s authority to issue guidance regarding the definition of “limited partner” for purposes of Section 1402(a)(13). Since that time Treasury and the IRS have remained silent on the issue.

Fourteen years later, the Renkemeyer decision threatened to open the debate again but since the IRS agreed with the decision and such decision was limited to LLC members within a very specific (and egregious) fact pattern, the argument remained dormant. Now, seventeen years after Congress thrashed the IRS for overstepping its bounds with regards to limited partners they are at it again.

In June 2014, Curtis Wilson, IRS associate chief counsel (passthroughs and special industries), said that the IRS had been thinking about the extent to which individuals who are limited partners under state law might be prohibited from relying on the SE tax exemption. Additionally, in the 2014-2015 joint Treasury-IRS priority guidance plan released August 26, 2014, the agencies announced they would tackle guidance on the application of Section 1402(a)(13) to limited liability companies.

The ILM is a clear indication that the Service has decided to go back on the attack against limited partner / LLC member utilization of the Section 1402(a)(13) exemption from SE tax. This may be another act of regulatory fiat that Congress will once again quash, as in 1997, but let the taxpayer beware. The IRS is of the opinion that active LPs should pay SE tax on their full allocation of management fee income. Management companies may be better off as S corporations which have a different statutory genesis for their SE tax exemption. But, of course, this begs the question. Why should different forms of passthrough entities receive different SE tax results? Stay tuned on this issue.

There are two basic types of business combinations – taxable and nontaxable.

Taxable Business Combinations (Asset Purchase):

In a taxable business combination, new tax bases for acquired assets and assumed liabilities are generally determined on the basis of the fair market value. The acquirer “steps up” the acquiree’s historical tax bases in the assets acquired and liabilities assumed to fair market value. Under the U.S. federal income tax law (IRC Section 338), certain stock purchases can be treated as taxable business combinations if an election to treat the stock purchase as a taxable asset purchase is filed.

Both the seller and purchaser of a group of assets that makes up a trade or business generally must use Form 8594 to report the transaction and both must attach the form to their respective income tax returns. The taxpayers are not required to file Form 8594 when a group of assets that makes up a trade or business is exchanged for like-kind property in a transaction to which section 1031 applies and when a partnership interest is transferred. For stock purchases treated as asset purchases under Sections 338(g) or 338(h)(10), the purchaser and seller must first file Form 8023, to make the 338 election. Form 8883 is then filed by both the purchaser and the target to supply information relevant to the election.

There is no legal requirement that the target and acquiring company take consistent positions on their respective tax returns, and therefore each could in principle take a different position favorable to itself. However, if they do so, the IRS is likely to discover this fact and protect itself by challenging the positions taken by both parties. To avoid this result, acquisition agreements almost always provide that the parties will attempt to agree on an allocation of price among the assets within a relatively short time after the closing of the transaction.

Non-Taxable Business Combinations (Stock Purchase):

In a nontaxable business combination, the acquirer assumes the historical tax basis of the acquired assets and assumed liabilities. In this case, the acquirer retains the “historic” or “carryover” tax bases in the acquiree’s assets and liabilities. Generally, stock acquisitions are treated as nontaxable business combinations (unless a Section 338 election is made). Nontaxable business combinations generally result in significantly more temporary differences than do taxable business combinations because of the carryover of the tax bases of the assets acquired and liabilities assumed. To substantiate the relevant tax bases of the acquired assets and assumed liabilities, the acquirer should review the acquired entity’s tax filings and related books and records. This information should be evaluated within the acquisition’s measurement period.

The non-taxable corporate reorganization Internal Revenue Code provisions are concerned with the form, rather than the substance, of the transaction. Therefore, it is important to document that the correct procedures have been followed. Regulation Section 1.368-3 sets forth which records are to be kept and which information needs to be filed with tax returns for the year that such a transaction is completed. Each corporate party to a non-taxable reorganization must file a statement with its tax return for the year in which the reorganization occurred that contains the names and EINs of all parties, the date of the reorganization, the FMV of the assets and stock transferred, and the information concerning any related private letter rulings. All parties must also maintain permanent records to substantiate the transaction. While there are no statutory penalties for failure to comply with the reporting requirements, the IRS has argued that failure to comply with the requirements could indicate that a transaction was a sale and not a non-taxable reorganization.

Way back near the end of May, which feels like a very long time ago, we published a couple of pages of overview on how to classify ownership interests in activities as passive vs. non-passive. Somewhere in that article I promised to mention how real estate interests can qualify as non-passive activities.

This determination is key in the proper treatment of income and losses both for the purposes of the limitations under the passive activity loss rules and also for the inclusion in the calculation of the new Net Investment Income tax.

For an activity to be considered non-passive, the owner must materially participate in that activity and generally meet one of seven tests enumerated in Reg. Section 1.469-5T, explained previously. Despite those requirements, rental activities are per se passive, that is, automatically treated as passive regardless of the level of the owner’s participation. There are a couple of exceptions to that default which we mentioned in the earlier article for self-rental activities, holding a working interest in an oil and gas property, and where a grouping election would be allowed with a non-rental activity in only specific circumstances. However, the most frequently used (and risky) exception to the default treatment of real estate income or loss as passive is when an election is made for a real estate professionals.

Special rules are provided under IRC §469(c)(7) for rental activities commonly referred to as the real estate professional rules. If the test is met, the rental activity of a real estate professional is treated as non-passive. Treatment as non-passive is advantageous when a real estate rental activity is generating losses that can be used to offset other income such as interest, dividends and wages. Conversely, the passive losses would not reduce other passive real estate income for purposes of the net investment income tax. Planning to make this election should be well thought out in that it may not always be desirable to treat net rental real estate income or loss as non-passive and the election itself may invite increased IRS scrutiny.

Am I a real estate professional?

The real estate professional must satisfy two tests:

more than one half of the personal services performed in trades or businesses by the taxpayer during such taxable year are performed in real property trades or businesses in which the taxpayer materially participates, and

such taxpayer performs more than 750 hours of services during the taxable year in real property trades or businesses in which the taxpayer materially participates.

At first glance, the test seems relatively easy to satisfy until you realize that for an activity to be counted towards the first and second test, the owner must materially participate in each activity to treat the income or losses as non-passive. If there are interests in several real estate activities, this may be difficult to satisfy. To help satisfy the material participation for each activity, a special grouping election can be made under Reg. Section 1.469-9 to treat all interests in rental estate as one activity. Once made, the election is binding for all future years the taxpayer is a qualifying real estate professional and is revocable only if there is a material change in facts and circumstances. In case you missed the election, one can be filed with an amended return under Rev. Proc. 2011-34.

The rental estate activity is owned by a trust. Can the trust be a real estate professional?

The Code nor the regulations address how material participation rules can be satisfied for taxpayers who are trust, estate or personal service corporations. Under IRC §469(c)(7)(B) the requisite amount of service hours must be performed in real property trades or businesses, the performance of which the IRS has previously stated must be by a taxpayer who is a natural person and has the capability for physically performing such services. In looking to case law for guidance, the U.S, Tax court in a recent decision, held that a trust taxpayer could meet the material participation standards through the performance of its trustees and thus qualify for the real estate professional exception under §469(c)(7). [Frank Aragona Trust, (2014) 142 TC No. 9.] In the case, the taxpayer was a trust that owned rental real estate properties and engaged in other real-estate activities. The court ultimately rejected the IRS’ argument that a trust is incapable of performing personal services. Rather, the Tax Court held that the trust is an arrangement whereby trustees have a fiduciary responsibility to manage assets for the benefit of the trust’s beneficiaries and therefore worked performed by an individual as part of their trustee duties are personal services for purposes of satisfying the section 469(c)(7) exception.

The trust was formed by a grantor who, after his death, was succeeded as trustee by his five children and one independent trustee. All six trustees acted as a management board for the trust and made all major decisions regarding the trust’s property. In addition, a disregarded LLC, wholly owned by the trust, managed the trust’s rental real-estate properties. The LLC employed several people, some of whom were the trustees. The court ruled that not only were the activities performed by the individuals in their duties as trustee included as personal services performed in a real-estate trade or business, but also their time spent as employees of the LLC managing the rental real estate properties.

Because the requisite hours in real-property trades were met and the trust materially participated in the real property businesses, the trust met the exception to the per se passive treatment of rental real estate activities and was able to treat the income and losses from the activities as non-passive.

The Philadelphia 76ers will construct an $82 million dollar state-of-the-art practice facility and team headquarters in Camden, NJ, aimed to be completed by 2016. Pursuant to New Jersey’s “New Jobs Investment Tax Credit,” the State has awarded tax credits to the 76ers over a 10-year period (not to exceed $82 million,) which should allow the team to recoup the FULL cost of building the complex.

The deal guarantees an $8.2 million tax credit annually that the Sixers can use or sell, so long as the team (1) employs 250 people in Camden, and (2) stays in the city for 15 years. If the team employee total at the facility drops below 250 in any year, the tax credits would be reduced to $5 million per year.

This specific New Jersey tax credit entitles corporate entities to a credit against the portion of their corporation business tax liability that is attributable to certain qualified investments in buildings, building components, equipment and capitalized start-up costs, in any new or expanded business facility in New Jersey, which results in the creation of a specified number of new jobs in the state.

The credit is determined by multiplying the amount of a corporation’s “qualified investment” by its “new jobs factor.” “Qualified investment” is determined based on the expected depreciation life of the property for federal income tax purposes, as depicted below:

property with a 3-year life—35% of cost;

property with a 5-year life—70% of cost; and

property with a life of seven or more years—100% of cost.

The “new jobs factor” is based on the number of jobs created in New Jersey which are directly attributable to the entity’s investment in the new or expanded business facility.

While the Sixers are required to provide 250 jobs to maintain the tax breaks, 200 of these positions are already filled by team administrators, players, and staff. Thus, only 50 new jobs will actually be created.

The 76ers are the only NBA franchise without its own practice facility, and the team has been using the Philadelphia College of Osteopathic Medicine for such purposes since 1999. The team will continue to play its home games at the Wells Fargo Center in Philadelphia.

The team’s individual players currently pay Philadelphia wage taxes on days they have home games, and pay other city wage taxes when the team is on the road. The players will eventually have to pay a New Jersey wage tax for the time they spend practicing in New Jersey.

One of the most common questions I get from clients relates to the structure of their potential real estate deals. While almost everyone has heard the age old adage “Never put real estate in a C corporation,” many people seem to see LLCs and S corporations as equally acceptable pass-through alternatives for holding real estate. In reality, this couldn’t be farther from the truth. The following will outline five reasons why an LLC is preferable to an S corporation for holding real estate in the current environment.

Number of shareholders – An S corporation is limited to only 100 shareholders. Under Sec. 1361, members of a family (as defined within the Code) are considered one shareholder for purposes of this 100 shareholder test. Conversely, there is no limit on the number of allowable members of an LLC. While this wouldn’t seem like a major limitation for a majority of property owners, if a taxpayer were interested in syndicating interests in the pass through entity in an effort to raise capital this 100 shareholder cap could significantly limit their ability to do so.

Type of shareholders – In addition to limiting the number of shareholders to 100, the Internal Revenue Code also limits the types of entities that can be shareholders of an S corporation. For starters, nonresident aliens are not permitted to own stock in an S corporation and certain types of trusts are excluded as shareholders as well. Neither C corporations nor partnerships and other entities taxed as partnerships under the default entity classification rules (multi-member LLCs) may not own shares in an S corporation. With an LLC, any type of entity, domestic or foreign, is a permitted member.

Only one class of stock – Many investors demand priority returns on their invested capital, as well as a priority return of their invested capital. In an S corporation, it is not possible to offer these benefits to investors. S corporations are only permitted to issue one class of stock. While the rules will permit an S corporation to issue voting and nonvoting stock, it is not possible to provide distribution or liquidation preference to certain shareholders at the expense of others. In an LLC, the allocations of cash are much more flexible and allow for these priority returns so long as the allocations meet the overall requirement of substantial economic effect.

Basis concerns – Many real estate investments offer losses in early years as a result of the benefits of accelerated depreciation deductions. These noncash deductions shield cash flow from taxation during the early years of the investment and generate losses that are allocable to the shareholders or members. The investors are only permitted to deduct those losses to the extent that they have basis in the pass through entity. I will avoid for now a long detour into the rules of both partnership and S corporation basis, but there is one major difference that is worth highlighting. Shareholders in an S corporation are only deemed to have basis in the pass through entity to the extent of any money invested into the entity and any loans made directly from the shareholder to the pass through entity. In an LLC, members are deemed to have basis for both their contributions into the entity and their ratable share of all liabilities of the entity. This allows members in an LLC to deduct losses in excess of their individual investment to the extent that they are allocable a portion of the liabilities of the entity.

Basis adjustments – The last way in which the two past through types differ is in the allowable adjustment to basis under IRC Sec. 754. This section of the Internal Revenue Code allows a partnership to adjust the basis of partnership property when there are taxable sales or exchanges of interests or redemptions of a partnership interest. There is no similar adjustment available to shareholders of an S corporation. This adjustment helps to keep a members’ outside basis in his or her partnership interest in line with the partnerships’ basis in the underlying partnership property. Since this opportunity does not exist for an S corporation, an S corporation shareholder can end up with a substantial variance in his or her basis in the S corporation stock, which could generate undesirable income tax consequences.

These five issues should be considered heavily when making a choice of entity. In most cases, one or more of these factors will make the choice of entity obvious. In more cases than not, an LLC will be preferred entity type for real estate investment. With an LLC, there is no cap on the number of shareholder and no limitation on the types of shareholders. In addition, a referred return on capital and a priority return of capital can be provided to investors without the fear of running afoul of the IRC rules. If none of the other issues outlined makes the decision, the optional basis adjustment under Sec. 754 alone can be substantial enough to point to an LLC as the preferred entity type. The Sec. 754 adjustment can provide significant tax advantages to an investor and should be given a good amount of weight in the choice of entity decision.

As I recover from the latest busy season, I took time to reflect on what was the most common question I was asked. Not surprisingly, it dealt with the material participation standards under Section 469 and the interplay with the net investment income tax under Section 1411

Although material participation rules are hardly new, they were given added importance with the introduction of the new net investment tax this filing season. This new tax forced many of us to reexamine with our clients, their participation throughout the year in business entities in which they own an interest. To complete the new Form 8960 we needed to go through the exercise of putting various ownership interests into separate buckets of nonpassive activities and passive activities, that is, activities in which the taxpayer materially participates or does not materially participate. This lead to further discussion on issues that we have always had to deal with such as passive loss limitations, grouping elections, self-rental rules and the real estate professional exception. Various common questions arose and are discussed in general below:

Is this activity passive or nonpassive? Usually this question arose in the context of whether or not the activity was subject to the new net investment tax. But, the answer tends to be more important for the reason for which the rule was first enacted: to limit the allowance of passive losses to the amount of passive income for the year. A passive activity is defined in IRC 469(c) as the conduct of a trade or business in which the taxpayer does not materially participate. A nonpassive activity is one that is not passive, and, therefore, one in which the taxpayer materially participates. So, meeting the requirements for material participation is key to this determination. Material participation is briefly defined in IRC Section 469(h) as involvement in the operations of an activity on a basis which is regular, continuous and substantial. The Temporary Regulations under Reg. 1.469-5T enumerate seven tests, any one of which can be met to satisfy material participation in an activity:

1) The individual participates in the activity for more than 500 hours during such year.

(2)The individual’s participation in the activity for the taxable year constitutes substantially all of the participation in such activity of all individuals (including individuals who are not owners of interests in the activity) for such year;

(3)The individual participates in the activity for more than 100 hours during the taxable year, and such individual’s participation in the activity for the taxable year is not less than the participation in the activity of any other individual (including individuals who are not owners of interests in the activity) for such year;

(4)The activity is a significant participation activity (within the meaning of paragraph (c) of this section) for the taxable year, and the individual’s aggregate participation in all significant participation activities during such year exceeds 500 hours;

(5)The individual materially participated in the activity (determined without regard to this paragraph (a)(5)) for any five taxable years (whether or not consecutive) during the ten taxable years that immediately precede the taxable year;

(6)The activity is a personal service activity (within the meaning of paragraph (d) of this section), and the individual materially participated in the activity for any three taxable years (whether or not consecutive) preceding the taxable year; or

(7)Based on all of the facts and circumstances (taking into account the rules in paragraph (b) of this section), the individual participates in the activity on a regular, continuous, and substantial basis during such year.

Withum Smith + Brown’s (“WS+B”) client base is very diverse. During my 10+ year career I have worked with clients from multi-national consolidated groups to start-up entities. No matter how big or small the company, I often am asked: “Is my current entity choice optimal from a tax perspective?”

To help our clients better understand their choices, WS+B created a chart that highlights the differences amongst the three most common entities (C-Corporation, S-Corporation and LLC).

Aside from the tax considerations, when choosing an entity, thought should be given to the current goals, long term goals and legal issues of the company.

The items in this blog are informational only and are not meant as tax advice. Consult with your tax advisor to determine how any item applies to your situation. A select group of Tax Professionals of WithumSmith+Brown write Double Taxation, and any opinions expressed or implied are not necessarily shared by anyone else at WithumSmith+Brown.

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Our tax specialists have a comprehensive understanding of international, federal, state and local tax regulations. We work with you to ensure tax reporting obligations are met in an accurate and timely manner, and to minimize or defer the payment of taxes, thereby adding value to your company. Through the use of technology, we stay up-to-the-minute on tax law changes, and know how they affect your business. Through our affiliation with HLB International, we can also assist you in developing cost-effective tax strategies anywhere in the world.